Economic and Financial Reform: Alternatives for North Korea

Abstract

IntroductionMore than 50 years after the signing of the cease-fire at Panmunjon, North Korea stands virtually alone as one of the last of the classical command economies. Like its other centrally managed counterparts, the North Korean economy was able to achieve reasonably rapid rates of growth through forced savings and high rates of investment, at least through the i970s. By the i980s, however, the economy began to stagnate and during the 1990s, as the political legitimacy of other command economies collapsed and trade relations deteriorated, the North Korean economy began a sustained decline exacerbated by bad weather and critical shortages of energy. According to estimates from the Bank of Korea (BoK, 2004), North Korea's per capita income in 1998 was only half of what it was in 1990.Reforms initiated in 2002, combined with some signs of interest in further reform from leaders in Pyongyang, have given a number of outside observers hope that North Korea is now seriously pondering more radical reforms that may finally lead to a significant and sustainable improvement in the standard of living for its 22 million citizens. There are many issues to be decided should North Korea embark on a reform process; however, reforms directed toward the financial system are fundamental to both extensive and intensive growth. Rapid extensive growth results from the combination of generating a high savings rate and investing these savings in projects with higher social returns. Classical socialist (i.e., command or centrally planned) economies are usually able to accomplish the former through administrative control over prices and limited production of consumer goods. The state is able to control how these savings are allocated through the state bank's monopoly over the financial sector; however, the institutions of the centrally planned economy have di[double dagger]culty ranking projects according to their social return. Intensive growth requires continued improvements in labor productivity, and though command economies can be successful at increasing the availability of education, they perform poorly at providing the incentives for such sustained improvement in productivity. In particular, a major source of productivity improvement is in the continuous selection of better technologies and production arrangements, a process requiring that ine[double dagger]cient operations be regularly shut down and resources shifted to other, more successful ventures.Financial sector reform is fundamental to supporting sustained extensive and intensive development because the financial system institutionalizes the saving and investment process, provides a system to evaluate and monitor credit risk, and imposes penalties for ine[double dagger]cient uses of capital. How financial reform is pursued in the development process determines the overall path of development.The rest of the paper is organized as follows. First, we review North Korea's macroeconomic performance and recent reforms to improve e[double dagger]ciency. This review relies heavily on Ahn (2003), Babson (2004), and Dwor-Frecaut (2004). Second, we review the general transformation of economic systems during the past three decades, from state-directed to market-directed regimes, in socialist and non-socialist economies, and note that the financial system is usually the first sector to liberalize. Third, we discuss the reform process in China as it shifted toward more marketdirect structures, and we suggest that China o∂ers the most useful lessons for North Korea; however, we also emphasize the policy errors that China has made with regard to financial sector reform that can potentially limit the outcome of the overall reform process. The specific problems with China reflect a more general problem that even less state-directed financial regimes such as Japan and South Korea have experienced. Fourth, we discuss the role of bankruptcy in the financial regimes of China, Japan, and South Korea. …